slides_intl2.ppt

The Global Economy

International Capital Flows

© NYU Stern School of Business

Suneet Weling

• Stern MBA 1998

• Dillon Read and UBS

– Director, Telecom Investment Banking

• Merrill Lynch

– Vice President, Media and Telecom Investment Banking

Group Presentations

Agenda

• In the news

• Are “external” deficits bad?

• Sources of external deficits

• Balance of payments and net foreign assets

• Sustainability analysis

• Is the US in trouble?

Are “external” deficits bad?

• External deficits:

– trade deficit

– current account deficit

– [ignore difference for now]

• Are external deficits bad?

Largest deficits (2006 est, USD billions)

United States –805

Spain –80

United Kingdom –40

Australia –35

France –31

Italy –24

Turkey –20

India –16

Portugal –13

Hungary –9

Source: IMF, WEO; current account.

Largest surpluses (2006 est, USD billions)

Japan 140

Saudi Arabia 130

Germany 122

China 121

Russia 120

Norway 67

Switzerland 40

Kuwait 39

United Arab Emirates 38

Netherlands 33

Source: IMF, WEO, current account.

Sources of external deficits

• Where do deficits come from?

• Recall

S = I + NX

Sources of deficits

Source: The Economist, 2004-2005.

CH

FR

Auz US

ES

SW

Jap

IT UK

Balance of payments

• Summary of “current flows”

– Merchandise trade

– Add trade in services: Net exports

– Add interest, taxes, and transfers: Current account

Balance of payments

• How is a current account deficit financed?

– “Inflow” of capital from abroad

– Equivalently: sell US assets to rest-of-world

– We say the current account is mirrored by an equal and opposite “capital and financial account”

Balance of payments

Country 1 Country 2

Capital

Goods etc

If Country 1 runs a current account surplus:

There is a capital “outflow” for Country 1, “inflow” for Country 2.

[Warning: the bottom arrow may seem backwards]

• BOP = CA + Capital/Financial Inflows = 0

Net foreign assets

• Examples of foreign assets

Net foreign assets

• International capital markets– Countries own claims on each other

– Net position (net foreign assets or NFA):

NFA = Claims on Foreign Countries – Foreign Claims on Us

• Changes in NFA:

NFAt+1 = NFAt + CAt + Net Asset Revaluations

≈ (1+i)NFAt + NXt + Net Asset Revaluations

• Comments – NX is like the primary deficit from fiscal policy

– Not quite, because CA includes some other things besides interest

Net foreign assets

Source: Economist, January 2005.

Sustainability analysis

• Are external deficits bad?

– They increase our foreign liabilities

– Which raises our interest burden

– But do they also increase our ability to pay?

• Analogy with a firm

– Which firms raise the most money in capital markets?

– How do firms and countries differ?

• Sustainability analysis

– Quick look at NFA/Y: how fast is it growing, and why?

– Missing: equity claims, asset revaluations…

Sustainability analysis

• Inputs

NFAt+1 = (1+i) NFAt + NXt

Yt+1 = (1+g) Yt

• Change in NFA/Y:

NFAt+1/Yt+1 = [(1+i)/(1+g)] (NFAt/Yt) + (1+g)-1 NXt/Yt

• Sustainability requires (1+i)/(1+g) < 1

i < g

• Typically i>g – Therefore something must change – but what?

Sustainability analysis: US

• Current numbers

– NFA/Y = –25%

– NX/Y = –6% (deficit)

– i = 5%

– g = 6% (3+3)

• Is the current situation sustainable?

– Where are changes in NFA/Y coming from?

– Are you worried?

Is the US in trouble?

• Stephen Roach, Morgan Stanley:

– Lacking in domestic saving, America must import foreign saving ... to keep growing at acceptable rates. And so America must then run massive and ever-widening current account deficits to attract that foreign capital. ... America now requires an average of $2.9 billion of capital inflows each and every business day to keep the magic going.

Is the US in trouble?

• Warren Buffet:

– As time passes, and as claims against us grow, we own less and less of what we produce. ... Should we continue to run current account deficits comparable to those now prevailing, ... our US ‘family’ will be delivering [a substantial fraction of] its annual output to the rest of the world simply as tribute for the overindulgences of the past.

Is the US in trouble?

• Nouriel Roubini and Brad Setzer:

– [We examine] ... US external deficits and the international monetary system that is integral to their financing – a system whose stability hinges on the willingness of Asian central banks to both hold enormous amounts of US Treasuries. ... The system is fragile. Our analysis suggests that the US is on an unsustainable and dangerous path.

Is the US in trouble?

• Choose one:

– We’re in trouble

– We’re fine

– Both of the above

Is the US in trouble?

• We’re in trouble – Low saving has led to large deficits, rise in foreign debt

– Debt service will consume a larger part of our budget

– Eventually consumption has to fall, and saving rise

– Adjustment could be precipitous

• We’re fine – Large flow of saving from oil producers and slow-

growing countries

– US remains an attractive place to invest

– Net worth position remains strong

– Deficit will probably go away once oil prices fall and/or Japan, Germany, etc start growing again

US flows 1

US flows 2

US net foreign assets

Swiss flows

German flows

Japanese flows

Saudi flows

US foreign interest burden

US net worth 1

US net worth 2

Is the US in trouble?

• Interest burden– Roubini-Setzer estimate in 10 years: 3% of GDP

• Compare to: fall in GDP growth of 0.5% a year

Is the US in trouble?

• Choose one:

– We’re in trouble

– We’re fine

Takeaways

• Balance of payments: flows of goods are mirrored by financial flows

– Current account deficit = capital inflows

• Current account deficits can reflect either high investment or low saving

– May affect ability to repay

• Whether deficits are good or bad depends on the use of funds

The Global Economy

Emerging Market Crises

© NYU Stern School of Business

Agenda

• In the news

• Volatility and crises

• Why?

• Traditional explanations

• Mexico and Korea

• Roubini on the Asian crisis

• Are the rich different?

• China

Iceland

• 5-6% growth in recent years

• Investment boom (hydro, aluminum)

• Trade deficit of >10% of GDP

• Fiscal deficit of about 3% of GDP

• Investors concerned, interest rates up

Iceland

• Today’s Financial Times:– Norway’s state pension fund has emerged as one of the

biggest investors to profit from the turmoil in the Icelandic bond markets, according to derivatives traders. Traders estimated that the fund, which invests Norway's large oil revenues abroad and is one of the biggest pension funds in the world, had made a profit of nearly €3m from shorting, or betting on the decline of bonds in Icelandic banks.

• Norwegian friend: – In principle, I’d much rather take advantage of the

Swedes.

Volatility (std dev of annual growth rate %)

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

US France China India Korea Brazil Mexico

Source: World Bank, World Development Indicators, GDP per capita, 1975-2005.

Volatility

Source: World Bank, World Development Indicators, GDP per capita, 1975-2005. Blue=US.

-.2

-.1

0.1

.2G

row

th R

ate

of P

er C

apita

GD

P

1970 1980 1990 2000 2010

US and China

-.2

-.1

0.1

.2G

row

th R

ate

of P

er C

apita

GD

P

1970 1980 1990 2000 2010

US and Korea-.

2-.

10

.1.2

Gro

wth

Rat

e of

Per

Cap

ita G

DP

1970 1980 1990 2000 2010

US and Brazil

-.2

-.1

0.1

.2G

row

th R

ate

of P

er C

apita

GD

P

1970 1980 1990 2000 2010

US and Mexico

Volatility

Source: World Bank, World Development Indicators, GDP per capita, 1975-2005.

-.15

-.1

-.05

0.0

5.1

Gro

wth

Rat

e of

Pe

r C

apita

GD

P

1970 1980 1990 2000 2010

US and Argentina

Crises

• Australia 1891-93 (“Barings crisis”) – GDP fell 18%

• United States 1907-08– GDP fell 10%

• Mexico 1994-95:– GDP fell 9%, peso fell almost 50%

• Korea 1997-88– GDP fell 9%, won fell 30%

• Argentina 1999-2002– GDP fell 20%, peso fell 65%

Crises

• Why?

Crises

• Crises reflect lack of confidence over repayment

– Could be internal or external

Current account review

• Current account deficits lead to foreign debt

• Viability of debt depends on what underlies it

– Worry if: deficit financed government or personal consumption (saving fell)

– Esp if it’s government debt and the political situation makes repayment politically difficult

– Don’t worry if: deficit financed new plant and equipment (investment rose)

– Unless: the investment isn’t paying off

• For later: Why might level of development matter?

Fiscal theory of crises

• Fixed exchange rate

• Government deficit leads to current account deficit

– Financed in part by issuing foreign debt

• Investors question repayment

– When do you hit this point?

• Investors stop buying debt (current account reverses!)

• Central bank unable to support exchange rate

– FX reserves run out, currency collapses

Exchange rate theory of crises

• Fixed exchange rate

• Over-valuation leads to current account deficit

• Investors question repayment

– When do you hit this point?

• Investors stop buying debt (current account reverses!)

• Central bank unable to support exchange rate

– FX reserves run out, currency collapses

Mexico

• Output fell 9%, peso collapsed

• Why?

Mexico

-.08

-.06

-.04

-.02

0.0

2R

atio

to G

DP

1990 1995 2000 2005

Mexico: Net Exports and Current Account

Source: IFS. NX=blue, CA=red.

Mexico

-.1

0.1

.2.3

Rat

io to

GD

P

1990 1995 2000 2005

Mexico: Saving, Investment, and Net Exports

Source: IFS. NX=blue, S=red, I=green.

Mexico

-.4

-.2

0.2

.4L

og o

f Re

al E

xch

ange

Rat

e

1990 1995 2000 2005

Mexico: Real Exchange Rate

Source: IFS.

Mexico

• Current account deficits in early 1990s

– Pre-NAFTA investment?

• Modest government deficits

• Panic followed change of power in December 1994

• Large drop in output, peso

• Current account reversed

• Economy rebounded

• Current account deficit resumed

Korea

• Output fell 9%, won fell 30%

• Why?

Korea

-.05

0.0

5.1

.15

Rat

io to

GD

P

1990 1995 2000 2005

Korea: Net Exports and Current Account

Source: IFS. NX=blue, CA=red.

Korea

0.1

.2.3

.4R

atio

to G

DP

1990 1995 2000 2005

Korea: Saving, Investment, and Net Exports

Source: IFS. NX=blue, S=red, I=green.

Korea

-.2

-.1

0.1

.2.3

Log

of R

eal

Exc

han

ge R

ate

1990 1995 2000 2005

Korea: Real Exchange Rate

Korea

• Modest current account deficits in mid 1990s– After years of limited international capital flows

• Fiscal surplus!

• Financial panic throughout Asia in 1997-98

• Current account reversed

• Economy rebounded

• Current account remains in surplus

Mexico and Korea

• How do they fit the theory?

Asian crisis explanation 1

• Foreign investors panicked for no reason

Asian crisis explanation 2

• Courtesy of Professor Roubini and friends

– Take his course if you want to know more

• Financial institutions financed bad private investments

• Left them unofficially insolvent

• Investors expected governments to bail banks out, which would lead to massive government deficits

• Massive expected government deficits led to crisis through the traditional fiscal route

Asian crisis evidence

• Every country different, but…

• Bad investments? – Sharp increase in non-performing loans

– Several chaebols insolvent

– Lax bank supervision allowed this to happen [weak institutions]

• Capital structure– Most foreign borrowing took the form of short-term debt

– Not: equity, FDI

– Why? Restrictions on foreign ownership and weak protection of equity creditors

Are the rich different?

• Political stability?

• Institutional protection of creditors

• Sophistication of financial markets

• What about Iceland?

Are the rich different?

• Are international capital flows (and foreign investors) a bad idea for developing countries? – Is trade in capital different from trade in goods?

China

• Is a crisis possible?

– How would you tell?

Takeaways

• Developing countries are volatile

• Fundamental factor in crisis– Investor concern over repayment

• Why rich countries are different– Better protection of investors

– Better capital structure (more equity, less debt)

• Why China may be different – Current account surplus, controls on capital flows

– Foreign claims are equity (FDI)

– Massive reserves

– But banking system is a mess